Slouching Towards Utopia?:
The Economic History of the Twentieth Century

-XIV. The Great Slump-

J. Bradford DeLong

University of California at Berkeley
and NBER

August 1996

In 1929 many economists saw business cycles as
unfortunate but unavoidable elements of economic development. Cycles in
GNP and employment were principally investment cycles. The value of investment
today depends heavily on future interest rates and growth rates. With an
uncertain future, there will inevitably be times when new information shows
that future growth has been overestimated, and that too much capital-or
the wrong kind of capital-has been put into place. The economy must then
shift resources from investment for the future to present consumption. This
shifting of resources out of the investment sector entails frictions that
temporarily reduce production and employment.

In this monetary overinvestment view, demand stimulation
is counterproductive. In a recession it keeps resources from shifting out
of the investment sector where their marginal product is less than their
resource cost, increases the overhang of excess capital, and thus deepens
and prolongs the subsequent depression; in a boom it increases the chance
that in the future new information will reveal that recent investment was
unproductive and so trigger a recession. Proper policy is "neutral"
so as not to disturb the market's balancing of savers' required real rate
of return and investors' expectations of the value of new capital. Proper
policy can moderate the business cycle, especially that part of the business
cycle that arises because the money supply is too elastic in response to
transitory demand shocks; but proper policy cannot be expected to come anywhere
near to smoothing out the cycle.

The "liquidationist" monetary-overninvestment
view of business cycles collapsed in the Great Depression. While the monetary
overinvestment view provided a framework for economists to analyze the busts
of the nineteenth and early twentieth century, its interpretation of the
Great Depression was found unconvincing. Periods of high unemployment lasted
not for months or years but for decades. They seemed too persistent to be
attributed to the frictions that resulted as the market reallocated productive
resources away from what were now seen as low value goods. Although workers
seemed willing to labor hard for low implicit wages-George Orwell, for example,
saw "...several hundred men risk their lives and several hundred women
scrabble in the mud for hours... searching eagerly for tiny chips of coal...
more important almost than food.," while "all around... are the
slagheaps and hoisting gear of the [idle] collieries" at which they
used to work.

In response to the high persistence of unemployment
in the interwar years, economists abandoned the idea that business cycles
were the economy's best feasible response to inevitable shocks to present
circumstances and expectations about the future, and that the Great Depression
had been generated by the largest such shock ever seen. Instead, they turned
to alternative--Keynesian--approaches to explain the persistence of high
unemployment, even though these alternative approaches were not so much
theories of business cycles as policy recommendations accompanied by promises
that supporting theories would be constructed later.

Some nations-Scandinavian countries that abandoned
the gold standard early-among the European, North American, and Australasian
set analyzed in Eichengreen and Hatton experienced the Great Depression
as little more than an ordinary recession, albeit in some cases beginning
from a position of relatively high unemployment in 1929. The collapse of
international trade in the 1930's idled resources in specialized export
industries, but for countries that had abandoned the gold standard early
domestic manufacturing took up the slack and returned GNP and employment
to relatively high levels by the middle of the decade. These fortunate nations
experienced the Great Depression as more-or-less another episode of "normal"
cyclical unemployment in response to a large shock, in this case the world
market's signal that export sectors were too large.

Other countries-largely nations like the United
States and France that remained on the gold standard beyond 1930-31-were
not so fortunate. Their unemployment rose to and remained at levels that
seemed too high to square with the normal mechanisms of standard business
cycles. There experience seems to have been an important key factor leading
economists away from "monetary overinvestment" theories and toward
"underemployment semi-equilibrium" theories.

Were economists right to judge that unemployment
was too high and too persistent to be interpreted as the best feasible redeployment
of resources in response to a large shock? Aggregate data-fragile as they
are-suggest that they were. Speeds of adjustment in the Great Depression
do seem much slower than in other recessions. For example, consider the
time-series properties of employment in the United States and the United
Kingdom. An error-correction model of the gap between actual and usual United
States manufacturing employment estimated over a pre-Great Depression 1900-1929
period finds an error correction coefficient of about 0.65 per
year; the economy closes 97% of the gap back to usual employment in three
years. But the same regression run over a 1924-1939 period that includes
the Depression shows a different picture: the error-correction coefficient
is about 0.20; the economy closes only half of the gap in three years. For
the United Kingdom, the analogous error correction coefficients are
about 0.55 and 0.20, respectively. These correspond to an economy that closes
nine and fifty percent of the gap to usual employment in three years,
respectively.

These regressions are useful as descriptions of
the data only. But as descriptions they are powerful. The self-regulating
mechanisms of the market appear to work less well in the Great Depression;
speeds of adjustment seem to slow down. Alternative propagation mechanisms
that give increased persistence to downturns appear to be at work. The search
for explanations of the Depression outside the compass of pre-1929 business
cycle theory thus appears well-motivated.

TABLE 1

MANUFACTURING EMPLOYMENT GROWTH REGRESSIONS

ANNUAL DAT
A

COEFfiCIENTS
OF:

Gap between Lagged

Sample Actual and Full Present Employment

Period Employment In_ation Growth R2
SEE

UNITED STATES

1900-29 .700 .681 .60 .053

(.124) (.155)

1900-29 .677 .709 -.091 .59 .054

(.148) (.167) (.144)

1924-39 .196 1.516 .71 .053

(.082) (.272)

1924-39 .162 1.674 -.157 .71 .053

(.090) (.321) (.166)

UNITED KINGDOM

1900-14 .563 .071 .17 .008

(.267) (.126)

1900-29 .512 .105 .31 .014

(.148) (.041)

1900-29 .594 .102 -.167 .30 .014

(.178) (.043) (.193)

1924-39 .158 .069 .41 .006

(.082) (.033)

1924-39 .203 .131 -.688 .59 .006

(.079) (.036) (.266)

Each paper in Eichengreen and Hatton presents its
own distinctive point of view on the question of why Depression unemployment
in the country it studies was or was not extraordinarily high and persistent,
and as a result the book is sprawling-as is inevitable in conference volumes.
Authors stress that France appears very different from Britain. They stress
that Australia's labor market adjustment process bears little resemblance
to that of the United States. Readers must extract the common themes and
contrasts of the interwar unemployment experience by themselves.

It is helpful to group the explanations for why
Depression-era unemployment was so high and lasted so long along two axes:
government-generated unemployment, and a shadowy and somewhat residual category
of market failure-generated unemployment. There are two candidates to take
the blame for the persistence of unemployment during the Depression: the
government, and the market.

Government-generated unemployment was widespread.
In Britain some unemployment (although a small share during the peak unemployment
years of the early 1930's) was surely generated by the government's unemployment
insurance system. Thomas cites Eichengreen's earlier work, which presented
a best estimate that some two or three percentage points of unemployment
in 1929-32 could be attributed to the operation of the relief system. Thomas
attributes some unemployment among secondary workers and unskilled young
men with large families to the "OXO" system in which firms
would systematically rotate two platoons of workers between time at work
and time receiving unemployment benefit, thus turning unemployment
insurance into a highly-subsidized work sharing scheme. Men receiving the
standard unemployment benefit in February 1931 had on average experienced
8.6 different spells of employment during the past year, working an average
of 151 days.

Given such rapid turnover it is not at all implausible
to argue that the availability of unemployment benefit, even with relatively
low replacement rates, allowed workers to remain in labor market positions
in which they were employed only half the time instead of migrating to some
other industry. Thus Thomas' essay tends to strengthen belief in Benjamin
and Kochin's (1978) argument that the underlying layer of excess British
unemployment-not the unemployment that prevailed in the deep slumps of 1922
and 1932 but the unemployment that prevailed in the relative booms of 1928
and 1937-may well have been maintained by the government's social policy.

Robert Margo's essay on the United States looks
at the situation as described in the 1940 census at the very end of the
Depression. At that time some 11.1% of U.S. heads of household were counted
as unemployed, of whom almost half-4.9% of all heads of household-held relief
jobs. Darby (1974) was the first to argue that the government had managed
to create a situation in which those on relief found themselves with little
incentive to register their labor supply on the private-sector job market
and yet were doing little socially productive work. Margo largely supports
Darby, thinking that relief jobs were attractive to many in spite of their
low levels of relief wages relative to average private sector wages. Relief
jobs were secure and required little skill. The risk-averse or the lesser-skilled
might well have found that their best option was to stay on relief jobs,
and be counted as unemployed, rather than take even an immediately available
private sector job.

Robert Salais' essay on France argues that the
development of bureaucratic mechanisms of relief for dealing with unemployment
in large part called forth the phenomena they were to address. The existence
of programs that would not offer relief except to the wholly unemployed
put pressure on the economy to shift its pattern of labor relations so that
it would adjust to lessened demand and slack not by reducing hours or returning
workers to agriculture but by creating the "unemployed."

In all of these cases there is no clear alternative
way of organizing the unemployment insurance system that would have been
a clearly better policy. A good society should offer support to those blocked
from earning their wages in the market. And a well-functioning economy should
create incentives for the unemployed to strongly register their excess supply
of labor in the market. These two goals are inevitably in tension. The inescapable
problem was that relief payments were too high for the short-term and too
low for the long-term unemployed, and that there was no good way to structure
relief programs to tell these two groups apart ex ante. William Beveridge
was among the first to lay out the policy dilemma: the long-term unemployed
"need... more money rather than less than those who have had short
periods of unemployment. Yet they can hardly be given more money without...
[creating an incentive] to settle down into permanent unemployment."
Moreover, few of the long-term unemployed can "escape physical and
psychological deterioration through long idleness."

In view of the general Keynesian orientation of
the editors Eichengreen and Hatton, the fact that their contributors argue
that government-generated unemployment played a significant role is
interesting. My reading of Eichengreen and Hatton led me to place more weight
on Benjamin and Kochin's and Darby's accounts of why unemployment was persistent
in the interwar period. Nevertheless, a large part of the puzzle remains:
Thomas, Margo, and the others note that slightly less than half of mid-1930's
unemployment was concentrated among long-term unemployed who did not take
advantage of subsidized relief-work schemes.

This form of unemployment, principally long-term
and somewhat of a residual category is, in the eyes of Eichengreen and Hatton
and their contributors, the key to the persistence of the Depression. Long-term
unemployment was strongly present in those countries that suffered worst
from the Depression, including non-European nations like Australia (compared
to the U.S. by R.G. Gregory, V. Ho, L. McDermott, and J. Hagan), Canada
(analyzed by Alan Green and Mary MacKinnon), and the United States and European
nations like Britain, Germany (discussed by Dan Silverman), Italy (discussed
by Gianni Toniolo and Francesco Piva), and the gold block nations of France
and Belgium (analyzed by Martine Goosens, Stefaan Peeters, and Guido Pepermans).
Of these only Germany achieved a strong recovery from the Depression in
the 1930's.

Long-term unemployment means that the burden of
economic dislocation is unequally borne. Since the prices workers must pay
often fall faster than wages, the welfare of those who remain employed frequently
rises in a depression. Those who become and stay unemployed bear far more
than their share of the burden of a depression, as Bernard Harris' discussion
of unemployment, insurance, and health in Britain shows. Moreover the reintegration
of the unemployed into even a smoothly-functioning market economy may prove
difficult, for what employer would not prefer a fresh entrant into
the labor force to someone out of work for years? The simple fact that an
economy has recently undergone a period of mass unemployment may make it
difficult to attain levels of employment and boom that a luckier economy
attains as a matter of course.

Indeed, long-term unemployment seemed stubbornly
resistent to activist policies. Stimulative policies may well have helped
cushion some countries' slide into the Great Depression, but once an economy
had fallen deeply into the Great Depression, devalued exchange rates, prudent
and moderate government budget deficits (as opposed to the deficits
involved in fighting major wars), and the passage of time all appeared
equally ineffective ways of dealing with long-term unemployment. Highly
centralized and unionized labor markets like Australia's and decentralized
and laissez-faire labor markets like that of the United States did
equally poorly in dealing with long-term unemployment. Fascist "solutions"
were equally unsuccessful, as the case of Italy shows, unless accompanied
by rapid rearmament as in Germany.

Eichengreen and Hatton's contributors have no clean
answers to the question of why the private sector could not find ways
to employ its long-term unemployed. The very extent of persistent unemployment
in spite of different labor market structures and national institutions
suggests that theories that find one key market failure responsible
should be taken with a grain of salt.

Perhaps the source of our puzzlement is our assumption
that the economy's laws of motion are more or less linear-that twice as
many excess unemployed should induce additional hiring and redeployment
of labor so that the number of excess unemployed drops twice as fast. But
should we be surprised that the long-term unemployed do not register their
labor supply proportionately strongly? They might accurately suspect that
they will be at the end of every selection queue. In the end it was the
coming of World War II and its associated demand for military goods that
made private sector employers wish to hire the long-term unemployed at wages
they would accept.